"My view is that the fatal flaw in Austrian economics is that it can’t explain unemployment — or, worse, that it thinks that it can explain unemployment, but is deluding itself. The Austrian view is that unemployment in a slump results from the difficulty of “adaptation of the structure of production” — workers are unemployed as resources are painfully transferred out of an overblown investment-goods sector back into production of consumption goods.

But this immediately raises the question, why isn’t there similar unemployment during the boom, as workers are transferred into investment goods production?"

The answer to that is of course that during the boom phase no businessman is suffering from lack of demand, and so no one needs to lay off workers, quite to the contrary, those in the investment sectors are seeing increased demand.

The problem is that this new source of demand is unsustainable, which means that these new businesses will eventually see a shortfall in demand, something which will cause them to lay off workers.

Krugman continues:

"I’ve asked this question repeatedly over the years, and all I get is one of two things: gobbledygook, or “but during the phase of rising investment, the economy is booming!”, which is of course circular. In practice, Austrians seem to be Keynesians during booms without knowing it; they realize that high demand produces a boom, but don’t realize that this contradicts their own theory of slumps."

What Krugman seems to think that anyone who even mentions demand in any way is a Keynesian-and furthermore that if you mention demand you must think it is the only factor. Both assertions are wrong, of course.

Yes, if some businesses are seeing increased demand while others don't, then this will produce booms. There is nothing necessarily Keynesian about recognizing that. He furthermore fails to mention how this is supposed to contradict the theory of slumps, which is that the end of this unsustainable source of demand is causing the slump. It seems perfectly consistent to me.

Perhaps Krugman believes that this contradicts the theory because the end of this source of demand supposedly means that there is a drop in "aggregate demand", and Austrians supposedly can't believe in declines in "aggregate demand". If you define aggregate demand as simply the quantitative sum of all purchases, then Austrians can believe in it since it is an accounting identity at that point. But the question is just how meaningful that accounting identity is.

The reason why Austrians don't think that the accounting identity "aggregate demand" is what we should focus on is because it misses the key causal factors at work. Since "aggregate demand" is equal to "aggregate supply" which in turn is equal to output, saying that slumps are associated with falling aggregate demand is really like saying that slumps are caused by slumps, meaning that it is in fact Keynesians which use a circular explanation of the boom and bust.

While Austrian theory agrees with Keynesian theory that some form of demand is driving the boom and that the destruction of that demand is driving the slump, what Austrian theory correctly describes unlike Keynesian theory is that 1) The boom is driven not just any form of demand, but by an unsustainable source of demand in the form of newly created money and by demand for capital goods industries (including the construction and consumer durable goods sectors) and that 2) When that demand disappears, the factors of production can move to other sectors only slowly or not at all, causing a decline in real output.

The Christian Science Monitor has assembled a diverse group of the best economy-related bloggers out there. Our guest bloggers are not employed or directed by the Monitor and the views expressed are the bloggers' own, as is responsibility for the content of their blogs. To contact us about a blogger, click here. To add or view a comment on a guest blog, please go to the blogger's own site by clicking on the link above.